Foreign Investment in China

China employment lawyersIn late 2017 an old and yet important set of China Employment laws —the Measures for Severance Payment due to Violation or Termination of Employment Contracts — issued by the then-Ministry of Labor back in 1995 was abolished by the PRC Ministry of Human Resources and Social Security. Since our China employment lawyers keep getting questions regarding the impact of this change I am writing this post to provide some clarification.

The short answer is that there are no significant changes. The fundamentals of China’s employment laws have not changed. China is still NOT an employment at will jurisdiction and its employment laws remain very local. 

The old Measures provided guidance on how to calculate statutory severance. They had some special rules for calculating severance payments, including (1) how a 12-month cap on severance would apply to mutual terminations or terminations for incompetence, (2) how severance was to be calculated using the average monthly wage for the 12 months prior to termination under “normal productions conditions,” and (3) how to calculate severance for employees terminated after various leaves of absence, for employees with contracts that can no longer be performed due to major changes surrounding execution of the employment contract, and for mass layoffs.

Before these Measures were abolished, many Chinese arbitrators and judges held that they had already been partially annulled because they conflicted with the China’s Employment Contract Law, but the legal outcomes on this issue were inconsistent.

When China’s Employment Contract Law took effect on January 1, 2008, it made clear that for terminated employment contracts severance payments under Article 46 of this Law shall be calculated based on the number of years of employment from the implementation date of this Law. The basic rule under the Employment Contract Law is that for each year (which is any period longer than 6 months) an employee has worked for the employer, he or she is entitled to one month’s wages in severance. For any period of employment of less than 6 months, the employee is entitled to half a month’s wages. If an employee’s monthly wage exceeds 300% of the local average monthly wage for the preceding year, the local average can be used to calculate the severance payment. In this situation, the number of years of service used to calculate statutory severance is capped at 12 years.

But the Employment Contract Law left open how to deal with an employee whose employment started before January 1, 2008. Before the mentioned Measures were annulled they were still technically in effect and this created several different methods for calculating severance. Subject to varying local employment laws, the specific method depended on: (1) the employee’s years of service with the particular employer; (2) how much time the employee put in working for the particular employer before January 1, 2008; (3) the employee’s average monthly wage during the 12 months before the employment contract ended or was terminated; and (4) the basis on which the employment relationship terminated or ended.

Not much has changed with the annulment of the Measures, though as is pretty much always the case with China’s employment laws, many of the specific changes (and lack of changes) will vary depending on the locale in which the employer is located.

Suppose the Measures were still effective and the employer’s locale does not have different local rules. An employee who worked for her employer since June 1, 1995 is terminated pursuant to a mutual termination agreement signed on January 1, 2018, According to China’s employment laws, the employee must receive severance. How do you calculate this employee’s severance if her average monthly wage during the 12 months prior to termination was greater than 300% of the local average monthly wage for the preceding year? If you apply the rules within the Measures, you would divide it into 2 periods in calculating the severance: (1) for the period before January 1, 2008, at her average monthly wage during the 12 months prior to the termination multiplied by 12 (because it would be subject to a 12-month cap); and (2) for the period after January 1, 2008, the severance would be 300% of the local average monthly wage for the preceding year multiplied by 10.

After annulment of these Measures the severance calculations under the above scenario do not change much. You still must divide it into 2 periods. Period one is the period before January 1, 2008 and her severance for that period would be calculated using her average monthly wage during the 12 months prior to her termination, multiplied by 13 (since the 12 month cap no longer applies); for period two, the period from January 1, 2008, her severance would be 300% of the local average monthly wage for the preceding year multiplied by 10. As you can see, in this scenario, the annulment of the Measures will increase the employee’s severance by 1 month at the average monthly wage during the 12 months prior to termination.

So at the end of the day, the most important factors for calculating severance payments are still how much the employee made during the 12 months prior to termination and when the employee started working for the employer. And of course, what your local employment rules say as well.

But whenever our China employment lawyers deal with China employment severance situations, our advise is usually not to get too bogged down with the severance amount because by far the most important thing is to make sure your termination is lawful. If you lack a legal basis (again, both under China’s national employment laws and under the local laws that apply to your specific business) for the termination there is little point in spending time calculating whether you have applied all the applicable severance caps.

And it is in the termination itself where our China employment lawyers most often see the big mistakes. Far too often foreign companies doing business in China terminate employees without a legal basis to do so. The easiest and safest way to terminate a China-based employee will almost always be via a mutual termination, using the minimum statutory severance as a starting point in your settlement discussions with your departing employee. When dealing with a mutual termination situation, paying the employee more than the minimum statutory severance does not invalidate the mutual termination agreement and doing so often makes sense as a way to secure a fast and relatively amicable resolution.

China AttorneysOne of the things my firm’s China lawyers are always saying and seeing is how China is constantly getting more legalistic, especially with foreign companies doing business in China. I used to believe this would lead foreign companies to become more careful, but this has not happened. Too many foreign companies — for all sorts of different reasons — remain far too nonchalant and increasing legalization only increases the likelihood this attitude will eventually harm them. In this series of posts (of which this is the first), I will write about the most common incidents our China attorneys see involving foreign companies that get into trouble in China for being careless or sloppy or just too trusting.

As for the title of this post, I have been studying Spanish for the last six months or so and oftentimes when I give a wrong answer my teacher will ask “¿Estás Seguro?” which means “are you sure?” I always respond by saying, “no, porque….” because I know she would not be asking this question if my answer were 100 percent accurate. I am asking the same question regarding China company formations because we far too often see instances where a foreign company believes one thing but the reality is something else entirely.

Forming a China company is a prime example of this, both with WFOEs and Joint Ventures. What usually causes the problem to bubble to the surface is different as between a WFOE and a Joint Venture, but what caused the problem in the first place is nearly always the same: the foreign company trusted without verifying.

The WFOE Problem. The WFOE problem is a somewhat simple one. The foreign company believes it has formed a WFOE in China (oftentimes long ago) and that it is now operating completely legally there. The foreign company typically then has a problem with its most important China “employee” and it wants to terminate that employee. The first thing our China employment lawyers usually do in this situation is to look at the official Chinese government corporate records for the WFO so as to get a better handle on the employee’s authority at the company. Sometimes we discover there is no WFOE.

At this point, the legal issue is no longer terminating an employee of a WFOE; it’s figuring out what makes sense in light of a messed-up China situation and a company’s present-day China goals. You cannot terminate an employee from a company that does not exist.

How does a company get to this point? What leads a company to believe it had a China WFOE when it didn’t? Ninety percent of the time the fatal mistake was trusting the person the company now wishes to terminate. That person claimed to have formed a WFOE for the foreign company but never did. Maybe he or she (though in my recollection it’s always been a he) formed a Chinese domestic corporation he owns. Or maybe this person never formed any Chinese entity at all. In any event, the foreign company  paid money to this person believing this money would be used to form a WFOE. Virtually always, the company then paid more money to this person believing this money would go to pay rent and personnel and taxes and other business expenses. Probably some of the money went to these things, but it is likely a good chunk of it went straight into the pockets of the person who lied about having formed the WFOE. Not sure why, the companies in this circumstance seem to be disproportionately Northern European. Just putting that out there.

The Joint Venture Problem. This is really two different problems. One, the non-existent Joint Venture, which is very similar to the WFOE problem, but usually a bit more complicated. The putative JV partner is put in charge of forming a China Joint Venture and it either does never forms any company at all or it forms a company in Hong Kong (or even in the United States, believe it or not!) that the foreign company believes to be a China Joint Venture. The foreign company thinks that the Hong Kong or US company owns a company in China and it thinks this corporate structure is itself a China Joint Venture. It isn’t and the China entity into which the foreign company ends up pouring time and money and technology is not in any respect owned by the foreign company. The foreign company then at some point becomes concerned about never having received any money from its Joint Venture and now the Joint Venture has gone completely silent and is not even responding to emails or the Joint Venture is now successfully competing directly with the foreign company. See China Scam Week, Part 6: The Fake Joint Venture.

Two, the foreign company trusted its Chinese Joint Venture partner and the lawyer its Chinese Joint Venture partner chose to prepare the necessary Joint Venture documents. Now there is a problem and those documents were written in such a way as to favor the Chinese side so completely there is nothing the foreign company can do to resolve it. See China Joint Ventures: The Tide is Out.

Do you have a Chinese company? ¿Estás Seguro?  Maybe you should double-check.

 

 

 

China Joint VenturesUnited States media has recently been frequently writing of how China forces foreign companies to relinquish their intellectual property to Chinese companies to be able to do business in China. This issue has been getting a ton of press lately because this is one of the justifications President Trump has been using to increase import tariffs on imports from China. It really isn’t this simple though. Many stories make it seem foreign companies must always relinquish their IP or at least must always do a joint venture to do business in China and doing a joint venture will mean losing your intellectual property.

Truth is that for most industries doing a joint venture is 100% voluntary on the part of the foreign party and truth also is that doing a joint venture need not include relinquishing your intellectual property. Much of the time foreign companies lose their IP to Chinese companies by falling prey to what the China lawyers in my firm call “the joint venture scam.” This scam is quite old — old enough for many Chinese companies to have thoroughly mastered it by now — and it usually works as follows:

  • The foreign company seeks to sell its complex and expensive technology to a Chinese company on a standard technology licensing basis.
  • After much discussion, the Chinese company asserts that the price is too high for an untested technology. The Chinese company then offers to establish a China joint venture company with the foreign company owning a percentage of the China Joint Venture.
  • The foreign company contributes its technical system in exchange for its ownership interest in the China Joint Venture and the China company contributes the rest. The IP contribution by the foreign company means the China JV now owns the technology for China. The China JV agrees to purchase more technology from the foreign company at full prices after the Joint Venture is up and running.
  • The foreign company then delivers and fully trains the Chinese side in how to operate the foreign company’s technology.
  • The China JV never purchases anything from the foreign company claiming that the foreign company’s technology does not work properly or as claimed. The foreign company eventually discovers that its technology has been cloned and is being used by a facially unrelated company in China. Since the China JV owns the technology, this unauthorized use probably infringes on the Joint Venture’s intellectual property rights, but so what? The JV must sue to defend its rights but because it is  controlled by the Chinese company its management refuses to take any legal action.
  • The JV then disappears, sometimes with the Chinese side buying out the foreign company at a substantial discount.

This system in various forms is still being actively used in China. And foreign companies still sometimes fall for it, but not you. Right?

For more on China Joint Ventures, check out China Joint Ventures, the 101.

China WFOE employment law
Get off on the right employment law foot when forming a China WFOE

Our China lawyers are constantly helping foreign companies set up companies in China — usually wholly foreign owned enterprises or WFOEs. As part of these WFOE formations, we help our clients with their employment matters that arise before, during and after the WFOE is formed. One of the things we always do for our WFOE formation clients is draft the employment documents they will need for their newly established WFOE.

When a WFOE is up and running, it needs employee agreements in place for all its employees. When we are called on to provide China employment law assistance to China WFOEs-to-be and freshly minted WFOEs, we usually recommend what we call an Initial Employment Package, which consists of the following for each employee:

  1. Employment Contracts
  2. Rules and Regulations
  3. Trade Secrecy and Intellectual Property Protection Agreements
  4. Sign Off Agreements, (acknowledging each employee’s receipt of the Rules and Regulations)

Having the above for your employees is crucial to operating as a WFOE in China with employees. If all you have is an employment contract, you are not fully protected. Specifically, your technical secrets or other trade secrets and the related intellectual property rights are not well protected as against your employees. And you likely will have no recourse against an errant employee no matter what the employee’s wrongdoing, since you do not have a set of China-centric Rules and Regulations to facilitate penalties or termination.

Your Rules and Regulations need to work for your specific locale(s), so if you have multiple locations in China, you need separate, standalone policies tailored for each location. Your employment contracts also should be localized. For more on the need to localize your China employment documents, see China Employment Law: Local and Not So Simple. We have worked with 1) companies with one WFOE and employees throughout China, 2) with companies with multiple WFOEs, one for each city, and 3) with WFOEs with branch offices in each city in which they have employees. Each of these structures require different documentation.

We also frequently draft non-compete agreements and these also virtually always need to be tailored to the specific situation, with that usually depending on the positions of the employees and their salaries and the shelf-life of the information that needs protecting.

Another common employment law issue we see with new WFOEs is what they can and should do with employees who work flexible hours. It is important to note that your new employees usually cannot be designated to work under China’s flexible working hours system until you have obtained the necessary government approval for the WFOE and it is up and running.

It pays to start with a strong employment law and document foundation for your China WFOE.

 

 

 

 

 

China employer audits China employment lawyers

As I have previously written, no (foreign) employer is too small for China’s regulators and in some respects the smaller you are, the more you need one. I say this because when a company with 5,000 employees has a problem with five employees, it’s not that big a deal, but when a five-employee company has a problem with two employees, it can be such a big and costly problem as to cost the company its China business. To be a well-protected employer in China, you need a well-written China employment contract and a China-centric set of Rules and Regulations, no matter your company size.

China’s employment laws are strict and protective of employees at all companies, especially those that are foreign-owned. If you as an employer fail to follow all mandatory employment laws, your employee will pursue you regardless of your size. Our China employment lawyers constantly get questions from China employers after they have been reported and/or sued by an employee China employee — mostly Chinese but increasingly non-Chinese as well.

The below is an amalgamation of the sorts of emails we frequently receive:

I cannot believe that I just got served with a lawsuit by one of my former Chinese employees. We are a small business and we pay all our taxes and we have always treated all of our employees right, including this one. We paid her really well and we were never late with her wages and we even gave her extra vacation days. We also paid all of her mandatory employee benefits and a few optional ones as well. We always did our best with her. And then she quit, completely voluntarily, and yet she is now suing and claiming we owe her double her monthly wages for not having a written employment contract with her? As you can see, her demand is totally unreasonable.

We then have to explain that with no written employment contract the employer stands virtually no chance in this arbitration.

It is not uncommon for foreign employers in China to state that they have done or are “doing their best” with respect to treating their employees well and following China’s complicated (and localized) employment laws. The problem is that neither the Chinese government nor its courts nor arbitral bodies care how hard you try. Your other law-abiding actions are not a mitigating factor in determining the penalty you will need to pay for having failed to enter into a written contract with your employees or for whatever other violation you may have committed.

The burden is on you as the employer to ensure you have a proper written employment contract fully executed by the parties. The best practice is to have your new employee sit down and sign a hard copy of the employment contract on her first day and you then retain an original copy of the fully executed contract for your records.

Consider this hypothetical. Employer asks Employee to sign a hard copy of the employment contract during the on-boarding process. Employee says: I will need some time to review this and I will take it home to read and I will return a signed copy. Employer says okay, but the Employee never returns a signed copy. Employer never makes an effort to “track down” that contract. Employee sues months or years later seeking a penalty from the employer for failing to use a written employment contract. Under this scenario, the Employer will be liable to Employee for failing to execute a written employment contract. If this sort of scenario sounds unlikely to you, let me just tell you that nearly every time we audit a company’s employment situation we find some percentage of employees working without signed contracts.

Now same facts as above, but Employee returns a signed copy with a fake signature. What will happen? Based on real cases with similar facts, Employer will probably be held liable for an employer penalty because there is no written employment contract bearing Employee’s actual signature, unless Employer has convincing evidence Employee faked the signature to “cheat the system” (which is a high evidentiary bar to meet).

If you are not sure you have current written employment contracts for all your employees, now would be a good time to check on this and fix it.

China Employment Law Female EmployeesAs today is International Women’s Day, this would be a good time for a quick overview on China employment laws that directly relate to female employees. Since there are so many national and regional and even local laws and regulations regarding female employees in China, this post necessarily seeks only to hit the high notes.

First, do not forget to give your female employees half a day off as International Women’s Day is their holiday (or follow the applicable holiday policy in your employer rules and regulations if it’s more generous than the law)!

Second, let me emphasize that female workers are always a big issue in China (not just today), primarily because they are accorded many additional special protections under China law. If you have been following my posts here or if you have a copy of my book (The China Employment Law Guide), you probably already know that employees who are pregnant, nursing or on maternity leave receive special protections exceeding those in many other countries. However, it is important to also note that these are not the only protected subgroups of female employees; they are simply the most often mentioned because the issues relating to them are the most common and because it is on these issues that foreign employers so often find themselves in trouble. For example, China’s laws also provide special protections for female employees during their menstrual periods. Many localities in China require employers provide a short (usually 1 to 2 days) paid leave to employees suffering from serious menstrual issues or to those with very heavy flows during their periods, so long as the employee provides a doctor’s note proving her condition.

Terminating a China employee is generally very difficult because China is not an employment-at-will jurisdiction and terminating a female employee is often even more difficult, especially if the female employee has a special status such as pregnancy. Subject to limited exceptions, employers in China are prohibited from unilaterally terminating an employee who is pregnant, nursing or on maternity leave. One common myth is that female employees in such special status can never be fired. This is wrong as these employees may be unilaterally terminated without severance for the employee’s failure to satisfy the employer’s conditions of employment during a probation period or if based on employee misconduct or wrongdoing. Alternatively, such an employee may be terminated if the employer and the employee agree to mutually terminate the employment relationship. See Terminating a China Employee: Why Mutual Termination is so Often the Key.

I will next month be putting on a webcast on April 18 on Employment Law for Female Workers in China. Do not miss it!

China WFOE Formation
China WFOE Formation. It’s complicated.

Yesterday, in the first part of this two-part series, I discussed how China is requiring foreign companies reveal all layers of WFOE ownership in the WFOE formation stage, I talked about how just as so many foreign companies are realizing the importance/necessity of forming a China WFOE, China has made it nearly impossible to form a WFOE without a full list of its owners. I first wrote about this issue in China’s New Foreign Investment Law: The “Actually Controlling Person” Requirement is Going to be Tough, but it is now at the point where the China lawyers at my firm are very clear with our clients who seek to retain us to help them form a China WFOE: you either reveal pretty much all owners of the WFOE-to-be (through the various layers of ownership) or your chances of getting a WFOE are not good. Clients unwilling or unable to make the required ownership disclosure in the exact form required by the PRC government authorities cannot proceed. There are no exceptions to the rule.

As noted in my earlier post, this is a threshold issue and this issue must be resolved before it makes sense to incur the time and expense required for aWFOE formation application.

China’s intent with this new [ownership disclosure] system is clear. The PRC government will no longer allow the use of special purpose vehicles and related entity structures to hide the actual ownership of the investors in PRC foreign-invested enterprises. And any attempt by a foreign investor to invoke a foreign law that allows secrecy with respect to ownership will [almost surely] be ignored. MOFCOM has plans to carefully audit all FIEs and that audit will include carefully reviewing their ownership structures. More important, however, is that a response that does not list out owners will simply not be accepted by the automated system. A response is therefore forced. A false response is a violation of law that can result in penalties and other legal/administrative action by the PRC government and its agencies.

Consider a typical private equity fund/venture capital type of ownership structure. The investor in the WFOE is Operating Company A. The owner of Operating Company A is a Holding Company B. Holding Company B is in turn owned by three private equity funds: Equity Funds C, D and E. The largest of the funds is owned by Equity Fund Z. As you can see, there are four layers of ownership.
For the MOFCOM information report, it is certain we will be required to disclose the following:
  • Operating Company A as the investor. This will require disclosing the officers and directors of Operating Company A.
  • Holding Company B is a 100% shareholder of Operating Company A. This will require we disclose Holding Company B, together with its officers and directors. We usually argue that Holding Company B is a “private equity fund”, and for that reason, we should not be required to disclose the shareholders of Holding Company B. Some MOFCOM offices will accept this argument. Some will not. Even if the local MOFCOM accepts, the higher level MOFCOM that does the later audit may not accept and then require all shareholders of Holding Company B be disclosed.
  • The local MOFCOM office may require disclosing the three shareholders of Holding Company B. If MOFCOM makes this demand, it will also require disclosing the directors and officers of Holding Company B. For the past several months, most MOFCOM offices have required this level of disclosure and foreign investors should plan on this disclosure being required.

The big question is whether MOFCOM will require moving up the chain to mandate disclosing the shareholders of the three shareholders in Holding Company B (Equity Funds C, D and E).  We have in the last few months been asked by various MOFCOMs for this level of disclosure, but we have so far been able to convince them that this should not be necessary. In one instance, we provided MOFCOM with an organization chart showing nearly 75 owners of an LLC (including many private equity funds) but ended up convincing it not to require our client disclose the names of these nearly 75 owners, as originally requested. When MOFCOM requests/requires this sort of disclosure, we normally argue that the C, D and E entities are “private equity funds” and disclosure of their ownership should not be required for the same reasons public company investors are not required to disclose their shareholders. Several local MOFCOM offices have recently tentatively accepted this argument, but this decision is not binding and the higher level of MOFCOM could demand more disclosure, either as part of the initial WFOE formation process or later as a result of their audit.

China has rejected shareholder secrecy and its requirement of full shareholder disclosure imposed on foreign investors is simply the consistent application of PRC law to all legal persons. The shareholder disclosure requirement is contrary to European and North American legal principles and on that basis many shareholders will refuse to consent to disclosure. However, under PRC law, there is no exemption. Moreover, as noted in Part One of this series, PRC local governments and MOFCOM offices are authorized to require even more sensitive private documents, such as the shareholders’ tax returns and tax returns of the WFOE’s foreign employees.
Bottom Line: If you are unwilling or even legally unable to comply with China’s ownership disclosure requirements you cannot proceed with a China WFOE formation. It is that simple and resistance is futile.
China Manufacturing Contracts
China WFOE Formation Ownership Disclosure: Like a Maze

Just as so many foreign companies are realizing the importance/necessity of forming a China WFOE, China has made it nearly impossible for a WFOE to be formed without a full list of its owners. I first wrote about this issue in China’s New Foreign Investment Law: The “Actually Controlling Person” Requirement is Going to be Tough, where I predicted what has now transpired.

It has reached the point now where we are very clear with our clients who hire us to help them form a China WFOE: either you reveal pretty much all owners of the WFOE-to-be (through the various layers of ownership) or the odds of your getting a WFOE are not good. Clients unwilling or unable to make the required ownership disclosure in the exact form required by the PRC government authorities cannot proceed. An Anti-Money Laundering Letter will be ignored and insisting on such a letter will only produce a hostile response. There are no exceptions to the rule.

This is a threshold issue and this issue must be resolved before it makes sense to incur the time and expense required for aWFOE formation application.

I provided the explanation for this in my earlier post:

China’s intent with this new [ownership disclosure] system is clear. The PRC government will no longer allow the use of special purpose vehicles and related entity structures to hide the actual ownership of the investors in PRC foreign-invested enterprises. And any attempt by a foreign investor to invoke a foreign law that allows secrecy with respect to ownership will [almost surely] be ignored. MOFCOM has plans to carefully audit all FIEs and that audit will include carefully reviewing their ownership structures. More important, however, is that a response that does not list out owners will simply not be accepted by the automated system. A response is therefore forced. A false response is a violation of law that can result in penalties and other legal/administrative action by the PRC government and its agencies.

Since I wrote that post, the China lawyers at my firm have found the local MOFCOM authorities are becoming even stricter about enforcing its WFOE ownership disclosure rules. The current trend is to require full disclosure all the way up the line of ownership. The only concession we have recently received is that some local governments will agree to end the disclosure at the level of what can be called a private equity or SICAR type fund. That is, some (not all) local MOFCOM offices will not require disclosing investors in private equity fund/SICAR type entities. However, other local MOFCOM offices DO require disclosure of private equity fund/SICAR investors.

There are though two levels of disclosure and getting past MOFCOM just means getting past the first level. The first disclosure is made in the information report provided to MOFCOM as part of the formation process. However, the new system includes an elaborate auditing process, so even if a local MOFCOM office allows for limited shareholder/ownership disclosure, an expanded disclosure may be required as a result of an audit. This is because the audit is done by a higher level office of MOFCOM. Such higher level offices are almost always stricter than the low-level offices.
So even if you are able to convince a local MOFCOM office to accept a limited disclosure of the shareholders of the investor, this is not a final decision. The initial MOFCOM decision can be overturned at any time and the demand for full disclosure can be made at any time. This demand would likely be made after your WFOE has started operations and if you then fail to comply with the demand your WFOE would be at great risk of being shut down.
Our European clients are usually the most taken aback by China’s new ownership disclosure requirements and we therefore often must spend extra time explaining the situation to those clients. Investor secrecy is at the heart of the European investment system. Most SICAR entities do not even disclose the identity of directors and officers. However, this form of secrecy has been rejected by the PRC government. For domestic companies that are not publicly listed entities, all shareholders are listed on publicly available websites. It is now possible to trace every PRC corporation up to the point of either a natural person shareholder or a public company shareholder. This is the system the PRC government intends to impose on foreign investors in China.
The investor disclosure requirement has become a fundamental policy in Chinese law. The PRC government fully understands that its policy of full investor disclosure is exactly opposite the investor secrecy systems standard in Europe and North America. Accordingly, any argument from a foreign investor that invokes European or international law is simply ignored as irrelevant. As noted above, as foreign entities have tried to resist fully disclosing their ownership, the PRC authorities have become more demanding, not less. We expect this trend to continue.
Note also that there are other disclosure risks, including the following:
  1. As part of the audit procedure, the PRC government may demand the tax returns of the disclosed shareholder(s) to confirm the accuracy of the reported information.
  2. It is nearly certain the PRC government will at some point require the WFOE provide three years of personal tax returns for each foreign individual employed by the WFOE.
  3. Other intrusive requests for what you likely will consider very private personal information may also be required during the life of the WFOE.
If you are not willing to provide the required information you should not move forward in trying to form a China WFOE because there is no way around these requirements. The PRC laws in this area are clear and the fact that those laws conflict with the laws and norms of Europe and North America is simply not relevant. What is relevant is that if you are not willing to comply with China’s ownership disclosure laws, you will not be permitted to set up and operate a WFOE in China.
As I wrote in my previous post, the “actual controlling person” requirement does not make legal sense under modern corporation structures, but the PRC government simply ignores this fundamental point. Thus, even after we do a full disclosure of all shareholders and thereby PROVE there is no single actually controlling person, the response of MOFCOM is to say: “You must identify the actual controlling person or we will not approve the investment.” Most local MOFCOM offices accept the name of the Chairman/CEO of the first level shareholder as the “actual controlling person.” Even that result though is not certain and there are two other possibilities:
  • The CEO/Chairman/Managing Director of the majority owning private equity fund or SICAR, no matter how far up the chain of ownership.
  • Endless requests for the name of the actual controlling person, when in fact there is no such person, making a response to the request impossible.
Our China attorneys have encountered all three of the above in our work on WFOEs during the period after the actual controlling person requirement was imposed. To date, there has been no consistency in the requirements.
In part 2 of this post, to come out tomorrow, I will discuss some of the specific situations we have encountered regarding ownership disclosure requirements when trying to register a China WFOE.
China employees during WFOE formation
Be safe. Hire after your China WFOE has been formed.

If you are a foreign (i.e., non-Chinese) entity with no legal presence in China, you cannot directly hire any employees in China. The basic rule is that you cannot hire a Chinese individual until after you have formed an entity (e.g., a WFOE) there and violating this rule can (and nearly always does) bring all sorts of bad things down on everyone involved. See Doing Business in China with Deportation or Worse Hanging Over Your Head.

What though do you do if you are in the process of forming your WFOE in China? Can you bring on employees during that time to assist with setup and other such things? Surely during this usually three to five month period, it is okay to bring on people and pay them as “employees” and then “convert” them over to legal status employees as soon as the WFOE is formed. Unfortunately, this is technically not allowed; there is no way for a foreign entity to hire a Chinese national “directly” unless and until it has an entity (a WFOE or a Joint Venture) in China. Sending illegal payments to your Chinese “employees” is not “hiring directly;” that is engaging in illegal activity before the WFOE is formed, and it is generally not a good way to start.

Though there is absolutely nothing in Chinese law that allows for “hiring” an “employee” before a WFOE is formed, the truth is that none of our Chinese lawyers have heard of anyone getting in trouble for this. This is not to say though that bringing on workers during the formation phase of your WFOE is not without risks. First off, past performance is no guarantee of future performance. Second, everything in China is somewhat local and that is particularly true of anything related to employment. See China Employment Law: Local and Not So Simple. In other words, what works in Shenzhen may not work in Shanghai, and vice-versa. And you must realize that for tax collection reasons the Chinese government is on a constant lookout for foreigners doing business in China without a WFOE and they have become exceedingly good at finding them.

The biggest risk of bringing on workers during the formation phase of your WFOE probably comes from the workers themselves. If things go well with them, no problem. But things very often do not go well with Chinese “employees.” Here is an all too common situation: a foreign company hires a Chinese person to work on the ground before the WFOE comes into existence. This Chinese person does something illegal in China and the foreign company informs the Chinese person that he is fired.  The Chinese person then says: “you cannot fire me because my engagement was illegal and that means you are operating illegally in China and everything I did that you say was illegal was done for the company and so you (the company) were doing illegal things too. I know more about these things because I am the one who was doing them but if I report them I won’t get in trouble for them, you will.”

If the foreign company terminates the employee that individual will no doubt files a lawsuit for unlawful termination AND report the foreign company to the Chinese government and then the WFOE and its management get in trouble, in addition to having to take the employee back because the termination was unlawful. The best resolution at this point is virtually always to reach a settlement with the “employee,” but because the “employee” has so much leverage in this sort of situation, the company usually has to pay quite a lot of money to extricate itself from the rogue “employee.”

Even after the WFOE is formed the new WFOE is at some risk of one of its pre-WFOE “employees” ratting it out for the pre-WFOE hiring, but that is much rarer. To ameliorate this risk, we always advise that you give your employees seniority and full other credit for any time spent working for your company during its pre-WFOE days.

Bottom line: Not bringing on Chinese employees directly while in the process of forming your China WFOE can be inconvenient, but it is always the safest route.

 

 

 

 

 

China Stock Options and SIPs
China stock options and share incentive plans

Companies often use share incentive programs to motivate employees by tying compensation to their service. Though no foreign person can own stock in a private Chinese company, it is possible for a PRC employee of a foreign company’s Chinese subsidiary to participate in the foreign company’s employee share incentive plan (“SIP”). However, due to China’s currency controls, whether such an employee can actually “cash out” on the benefits of such a program depends on whether the foreign company is or becomes listed on a foreign stock exchange at the time of exercise.

The primary rules on PRC citizen employees participating in a foreign company’s SIP come from the Circular on Foreign Exchange Administration of Domestic Individuals Participating in Share Incentive Plans of Foreign Listed Companies [2012] No.7 (“Circular 7”,  issued by the State Administration of Foreign Exchange (“SAFE”).

  • Registration and Designated Account

Under Circular 7, a foreign listed company can offer SIPs to its PRC subsidiary’s employees in China via an incentive plan. The incentive plan must be registered with the local SAFE office where the foreign company’s domestic agent is located. This domestic agent can be the PRC subsidiary of the foreign listed company participating in the SIP (if multiple places, then the location of the headquarter) or a third party domestic entity that is qualified to provide asset custodian services.

Once the registration is complete, the domestic agent must open and maintain a domestic foreign exchange account designated for handling foreign payments and collecting money for all domestic individuals participating in the SIP of the overseas listed company. Any payments under the incentive plan must go through this special account before they go to an individual participant’s bank account.

Again, just like China employment contracts, we cannot emphasize enough how SAFE registration is highly local. It is critical to consult with the local SAFE office about specific requirements for registration before submitting an application. And just as is true of pretty much anything and everything in China, you do not want to get halfway through the process before you realize you are doing it wrong because this will make doing it right more difficult or perhaps even impossible.

  • Type of Awards Covered

Under Circular 7, share incentive plans mean any incentive plan where the shares of the foreign listed company are offered to directors, supervisors (officers who supervise directors and senior management of a company, a position created under the PRC Company Law), senior management employees, other employees of the domestic company or individuals who have a labor relationship with the domestic company. This includes employee stock option plans, share ownership plans, and any incentive plans permitted by law.

Though Circular 7 does not enumerate the specific types of awards to which it applies, the relevant registration form provides checkboxes for the following types of awards: stock ownership plans, stock options, stock appreciation rights, phantom stock, restricted stock (units), performance shares (units), and stock purchase plans.

  • Nationality of Participants

Circular 7 defines “domestic individuals” as directors, supervisors, senior management and other employees within the scope of article 52 of the Regulation on Foreign Exchange Administration who are PRC, Hong Kong, Taiwan, and Macao nationals, and other foreign nationals who have resided within China for one year on a continuous basis, except foreign diplomats in China and the representatives of any international organizations in China.

  • PRC Employees and Foreign Private Company Incentive Plans

Certain special rules apply to special purpose vehicles (foreign companies established or controlled by PRC residents or organizations) and PRC law and Circular 7 are silent on domestic individuals participating in purely foreign private companies’ SIPs. This does not mean Chinese individuals are not allowed to participate in a foreign private company’s SIP, but the lack of clear legal authorization makes it practically impossible for PRC individuals to receive benefits or awards under those plans if the foreign company is not yet public by the time of exercise.

And again, because SAFE registration is so highly localized, even though the law does not require registration of a private foreign company’s SIP, it is advisable to consult with the local SAFE office and attempt registration anyway. It doesn’t hurt to ask.

A foreign company with a concrete plan to become publicly listed in the near future can enter into an agreement with its employees in China to offer stock option or other awards. If the company does go public as planned, such awards can then be registered with SAFE and special accounts can be created to process payments in compliance with PRC laws. However, when entering into such agreements, the company should also make sure its employees in China understand that if the company does not go public, the employees may never receive SIP related proceeds due to China’s foreign exchange control rules.